Question

You are a pension fund manager looking for an investment that will provide a reliable stream of income over the next 5 years. You want to find the best yield possible while still conforming to the pension fund covenant of investing in investment grade bonds or better. Decide among the following investment options for your fund.

a. Eastern Telecommunications Inc.: 5 years, 10% yield, EBIT Interest Coverage ratio = 4.4, EBITDA interest coverage ratio = 5.8, total debt of $72,625,000 (all of which is long term), total equity of $175,000,000, and a return on equity (ROE) of 7.9%.

b. Anderson Nuclear Power: 5 years, 15% yield, EBIT Interest Coverage ratio = 0.75, EBITDA interest coverage ratio = 0.9, total debt of $48,000,000, total equity of $70,000,000, and a return on capital (ROE) of 7.8%.

c. Titan Tech Company: 5 years, 6% yield, EBIT Interest Coverage ratio = 24.1, EBITDA interest coverage ratio = 30.5, total debt of $90,000,000 (all of which is long term), total equity of $1,500,000,000, and a return on equity (ROE) of 19.9%.

The following table shows the three-year median ratios for U.S. Industrials with long-term debt. Use the table to discuss the pros and cons of each investment option, described above. Determine the grade of each bond (as closely as you can). Which bond is appropriate for your pension fund?

	AAA	AA	A	BBB	BB	B	CCC
EBIT Interest Coverage	21.4	10.1	6.1	3.7	2.1	0.8	0.1
EBITDA Interest Coverage	26.5	12.9	9.1	5.8	3.4	1.8	1.3
Return on equity (%)	34.9	34.9	19.4	13.6	11.6	6.6	1.0
Long-term debt/equity (%)	13.3	13.3	33.9	42.5	57.2	69.7	68.8
Total debt/equity (%)	22.9	22.9	42.5	48.2	62.6	74.8	87.7

Answer:

a. Eastern Telecommunications Inc.:

b. Anderson Nuclear Power:

c. Titan Tech Company

d. Summary recommendation:

Answer 1

Part A

Eastern Telecommunications Inc.: Eastern’s issue is wobbling between a high yield bond and an investment grade bond. With interest coverage ratios coming in right at the BBB benchmark and a long-term debt/equity ratio of 41.5% ($72,625,000/ $175,000,000), which is also approximately right at the BBB benchmark it is likely that this bond is a feasible investment option, especially taking into the consideration attractive part is the 10% yield. Interest coverage ratios and long-term debt/equity ratio are favorable but not ROE. Eastern Telecommunications Inc.’s ROE is well below the BBB benchmark and could be a cause for concern.

Part B

Anderson Nuclear Power: The bonds of Anderson Nuclear Power are high yield bonds, considering a profile that lies somewhere between a B grade bond and a CCC grade bond. The most troubling factor is the interest coverage ratios, which are both below B grade. Being the high yield, there is high risk associated with it inherently. There is a quite high possibility that it will default, and therefore it would be an inappropriate investment for a pension fund.

Part C

Titan Tech Company: the long-term debt/equity ratio 6.0% ( $90,000,000/ $1,500,000,000), the ROE of 19.9%, and interest coverage ratios of AAA quality are all attractive features of Titan Tech Company’s bonds. They look to be approximately a AAA quality bond. Thus, this company is considered healthy, and thus makes this bond a relatively safe play.

Part D

Summary recommendation: The investment in the bonds of Titan Tech Company is the most appropriate bond for a pension fund. Though it offers a lower yield, the risk associated with it is also low. The management of pension fund is related to preserving capital rather than earnings high returns and all this is possible with the investment in Titan Tech Company’s bonds.